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Erica Duignan Minnihan

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When it comes to early stage investing, there is so much to learn and an ever-evolving landscape. And there are some great books out there that can help you establish a solid knowledge base in this asset class.

Most people who talk about angel investing or early stage investing in general often accompany it with a stern warning: “Be ready to lose all of your investment.”

And while this is definitely a possibility, we know that avoiding the companies that implode in a spectacular fashion is half the battle to building a portfolio with a strong IRR. For every company that goes completely bust, you need to generate a 2x return from another investment just to break even.

So here are our top ten warning signs to look out for when you are considering an investment.

One of my clients, Jeff, is a high net worth individual who has worked in finance for years. Although he is very familiar with stock market investing, he was a little stumped when it came to understanding the nuances of startup investing.

He was looking at two different deals. Both had great founders, a great market opportunity and some good initial traction. One was raising $2 million at a $10 million valuation and the other was raising $1 million at a $5 million valuation. He wasn’t sure what to do.

“How do I calculate the PE ratios? How do I know what the market cap is going to be?” In short, he needed to know how to evaluate this very special asset class that is a startup investment. And the tools he learned to evaluate public market investments weren’t going to be very helpful to him in this case.

Venture capital is money provided by investors to startup firms and small businesses with perceived long-term, high-growth potential. This is a very important source of funding for startups that do not have access to capital markets.

Although these investments are much higher risk than public market investments, they also tend to have much higher expected return potential. This high-risk, high-return-potential asset profile makes it very important to take a portfolio approach when making venture investments.

Venture Investing has become a very important source growth capital for the US economy over the last 30 years. More and more innovation is happening outside of large corporations and inside small, nimble startups. Do you wonder why that is the case?

The “portfolio effect” is the decrease in overall risk in a portfolio of high-risk, but relatively uncorrelated assets. In venture investing, it typically refers to the strategy taken by experienced investors of investing smaller amounts of capital into a fairly large number of startups, rather than putting all of their capital into one or two companies.

It is often very hard to predict exactly which of a group of high growth potential startups will end up as the “winner-that-takes-all”, so better risk-adjusted returns can be achieved by investing in a portfolio of 30 high quality companies over time. Even 5 small investments per year is enough to make a significant difference in the expected returns.